While the world worries about Greece and Spain, Japan also has its share
of debt problems. Are financial markets missing the real problem?
Predictions of the date may
differ, but the general consensus on Japan remains the same. In a matter of
just three to 10 years, the world’s third-biggest economy may start running out
of the savings needed to fund its massive public debt.
Is it time to start selling yen,
or are the doomsayers off target concerning the world’s biggest creditor
nation?
The days of Tokyo’s finance
mandarins being admired for their fiscal prudence are long since gone.
According to the International
Monetary Fund, Japan’s general government debt first broke above 100 percent of
gross domestic product (GDP) in 1997 as the authorities tried to pump prime the
economy out of its post-bubble funk.
Ending the credit binge – and its
famous “bridges to nowhere” construction projects – has proved challenging for
governments dealing with a deflationary downturn, rising welfare costs and
dwindling tax revenues.
In 2011, general government gross
debt totaled nearly 230 percent of GDP and is projected to reach 245 percent in
2013, with the government’s fiscal deficit currently around 10 percent of GDP.
Net public debt, which subtracts
from gross debt government assets such as public pension funds, has also
increased tenfold over the past two decades to reach more than 125 percent of
GDP.
In comparison with Europe’s
indebted economies, Greece reached crisis point with its debt to GDP ratio of
just 150 percent, while the Spanish government has faced a storm with a debt
ratio below 100 percent.
Prime Minister Yoshihiko Noda,
the first leader since Ryutaro Hashimoto in 1997 to raise the sales tax –
Hashimoto’s move cost him his job – has already sounded the alarm.
"The European debt crisis is
definitely becoming something that is not just someone else's problem,"
Noda has said. "We’re aware that it’s an urgent situation and want to
explain that properly to our countrymen."
Despite the urgings of economists
and finance bureaucrats, it took a bruising political battle for Noda to
succeed in pushing through a consumption tax hike seen as barely containing
projected growth in welfare spending.
The increase in the consumption
tax to 8 percent in April 2014 and 10 percent in October 2015 received approval
in August, but Noda was forced to pledge to call fresh elections “in the near
term,” a vow that the opposition has used to block a key debt issuance bill in
hope of forcing elections by year-end.
Should the bill not be enacted by
the end of November, the government has warned it will run out of cash,
prompting warnings from credit-rating agencies of another downgrade in Japan’s
sovereign debt rating as well as volatility in the bond market.
Meanwhile, an aging population,
declining birthrate and a contracting workforce are putting pressure on
household savings, adding to concerns that the nation’s legendary savers will
no longer be able to buy government bonds.
According to a McKinsey study,
savings rates in Japan decline markedly after the age of 50, meaning that the
rising proportion of elderly will further diminish household savings.
In addition, the cost of
increased energy imports to cover the shutdown of nuclear power plants has
eroded the trade balance. Exports to Japan’s biggest trading partner, China
have been hit by a slowdown that may mark the end of double-digit growth in the
Middle Kingdom.
In its August 2012 report, the
IMF warned that “even a moderate rise in yields would leave the fiscal position
extremely vulnerable…Failure to implement a credible fiscal consolidation plan
could lead to sovereign downgrades and trigger similar actions for financial
institutions, which could eventually erode confidence in the JGB [Japanese
government bond] market.”
Higher JGB yields would further
damage public finances, with the government’s budget already at a point where
bond issuance exceeds taxation revenues. The IMF calculates that a spike in
bond yields would slash output by 6 to 10 percent over 10 years, potentially
harming not only other Asian economies but also the United States and Eurozone.
‘Crisis overstated’
Despite the highest public debt
to GDP ratio in the industrialized world, Japan remains the world’s biggest
creditor with net foreign assets of around US$3.1 trillion, with its 2011 per
capita GDP of US$34,294 above Italy, Spain and South Korea and four times the
size of China’s.
Household assets of an estimated
1,500 trillion yen, surplus funds held by the private sector and the demand
from Japanese banks and other financial institutions for low-risk investments
have given the government a ready market for its JGBs.
In addition, Japan’s low ratio of
taxes to national income provides scope for increasing the burden. According to
OECD data, Japan’s 27.6 percent ratio in 2010 compared with the United
Kingdom’s 35 percent and was below the average 33.8 percent of tax revenue as a
percentage of GDP.
Japan economist Jesper Koll,
Japan Director of Research at JP Morgan, said while the nation’s current
account surplus would fall into deficit “in early 2015,” the crisis had been
“overstated” and the nation was in no danger of becoming another Greece.
Thanks to a steady stream of
income from foreign assets – an amount that may increase due to the past year’s
record overseas investments – the current account has remained in surplus even
as the trade balance declined.
“Japan is not Greece as it funds
its own debt, whereas in Greece 70 to 75 percent of government bonds were owned
by non-Greeks. Crises happen when your creditor goes on strike, and the fact is
that Japan’s debt is held almost exclusively by the Japanese themselves so any
comparison just doesn’t make sense,” he said.
Unlike Greece, Spain and other
members of the Eurozone’s monetary straightjacket, Japan has its own currency
which could prove an important advantage, Koll added.
“If it comes to a point where
domestic savings can’t fund the deficit any more, the currency is likely to
weaken, making yen assets such as Japanese bonds more attractive. That’s
something you can expect to happen from late 2014 to early 2015 onwards,” he
said.
“The fact that it hasn’t weakened
yet and has continued to strengthen shows you the Japanese are capable of
funding their debt. Once the yen starts to weaken, that will be in parallel
with Mr and Mrs Watanabe no longer having enough savings and Japan needing to
attract money from American pension funds, for example.”
Junko Nishioka, head of research,
Japan at RBS Securities said the fiscal deficit was likely to continue to
worsen.
“The fiscal deficit is already
around 10 percent of GDP, and considering there’s no way for the Japanese
government to further support the economy, the deficit is likely to increase
further,” she said.
While Nishioka said the current
account surplus would help keep JGB yields low, the situation could change
soon.
“We expect the current account
balance to fall into negative territory after 2017, if you assume there’s no
resumption of nuclear power plants under the DPJ [Democratic Party of Japan]
policy,” she said.
“This would increase the fiscal
risk, but Japan also has massive foreign reserves and external assets, which
are likely to cover the current account deficit likely in 2017 or 2018.”
1997 all over again?
PM Noda succeeded where others
failed in increasing the consumption tax, a move that, like Hashimoto in 1997,
may cost him his position at upcoming elections due next year at the latest.
However, the tax hike is expected
to generate only an additional 10 trillion yen a year in revenue, below the
expected 10.9 trillion yen annual rise in spending due to higher pension costs.
Spending on seniors already
accounts for around 30 percent of the annual budget, and with lawmakers
reluctant to curb benefits the situation is likely to worsen. Nearly a quarter
of the nation’s 127 million population is over the age of 65, and this
proportion is forecast to reach 40 percent by 2060.
According to the OECD, Japan’s
tax revenue in 1991 totaled some 66 trillion yen in individual and corporate
income taxes. By 2009, this had fallen to 36 trillion yen, with bond issuance
exceeding tax revenues in fiscal 2012 for the third straight year.
The IMF has warned that the
increase in consumption tax goes only halfway toward achieving a desired fiscal
adjustment of 10 percent of GDP over the next decade to put the debt ratio on a
downward path.
With some fiscal adjustments, the
public debt to GDP ratio is forecast at 300 percent of GDP by 2030, with
further cuts deemed necessary to stabilize and then start reducing the ratio.
Bringing the primary balance,
where fiscal expenditures can be covered without borrowing, into equilibrium is
estimated to require an additional 5 to 6 percent hike in the consumption tax.
The government has forecast a
primary deficit of between 1.9 and 3.1 percent of GDP by fiscal 2020, compared
with the fiscal 2011 deficit of 7.4 percent.
RBS’ Nishioka said the tax hike
“wasn’t enough” to cover rising welfare spending, saying the next government
would have to consider further cost cuts as well as tax increases. Some
economists have even called for the consumption tax rate to climb to 16 or 17
percent to eliminate the budget deficit.
Yet when Hashimoto increased the
rate by just two percentage points to its current level, the economy plunged
into a 20-month recession, albeit worsened by the Asian financial crisis.
While forecasting a mild
recession this summer before a recovery in 2013, JP Morgan’s Koll said he was
less concerned about the impact of the consumption tax hike.
“It’s the right thing to do as
Japan has a very inefficient tax system, so raising the tax base by lifting the
sales tax helps build a better system that actually will collect revenue if and
when the economy starts to grow,” he said.
“With luck, by the end of 2013
the global economy will be in better shape and there will be recovery momentum
in Europe beginning to emerge. You have to start somewhere and I’m not worried
about this pushing Japan back into recession.”
Koll said the government had also
managed to cut its payroll costs by reducing public sector pay and pensions – a
“step by step” process to reduce the government wage bill.
Structural reform or inflation?
Proposed solutions to Japan’s
economic woes have included measures to deregulate the agricultural,
electricity and service sectors, along with the politically sensitive measures
of joining the Trans-Pacific Partnership and increasing immigration.
The IMF has suggested the fiscal
consolidation include raising the consumption tax rate to 15 percent – closer
to the OECD average – while reducing corporate taxes, broadening the personal
income tax base and increasing the pension retirement age to 67.
“If the consolidation was coupled
with structural reforms to support growth, it could boost confidence and help
raise private consumption and investment over the longer-term,” it said.
Venture capitalist Hitoshi Suga
suggested a “debt-equity swap” where the government converted JGBs into
100-year debts, similar to Britain’s “perpetual bonds” issued after the First
World War, as well as more fiscal prudence.
“The Japanese government must
learn how to use funds more efficiently, liquidate and sell its unnecessary
current assets which amount to a substantial percentage of the debt, rather
than increasing consumption and other taxes and raising social welfare
insurance premiums,” he said.
“Importantly, healthy economic
growth should be strategically planned and implemented to increase tax revenue
automatically and substantially.”
Another solution has come from
the World Economic Forum, which in its Gender Gap Report for 2012 noted that
some studies have found “closing the gap between male and female employment
would boost Japanese GDP by as much as 16 percent”.
However, the easiest fix might
come from that bugbear of central bankers everywhere: inflation.
Rising inflation helped the
United States nearly halve its debt burden from World War II over the period
from 1946 to 1955, but Japan’s policymakers, including the Bank of Japan (BOJ),
have struggled in recent years to overcome persistent deflationary
expectations.
However, with the current BOJ
governor, Masaaki Shirakawa’s, five-year term expiring next April, the nation’s
then political leader will have the perfect opportunity to force a policy
change.
Should Liberal Democratic Party
(LDP) leader Shinzo Abe win office, the BOJ would be under pressure to escalate
its quantitative easing policies, according to Koll.
“Mr. Abe wants an outright
inflation target of 3 percent, rather than the current 1 percent figure,” Koll
said, saying that fundamental change was only likely if the LDP took the helm.
“The BOJ has always done the
right thing, but it’s fairly easy to accuse it of doing too little, too late
compared to what we’ve seen in America and Europe,” he added.
Ironically, despite its recent
crises, Europe offers an example to Japan of managing fiscal reconstruction
while also raising growth. Both the Netherlands and Sweden achieved this feat
in the 1980s and 1990s through persistent public finance reforms along with
greater labor market mobility and other market opening measures.
Pulling off the same success
would go a long way toward ensuring that the sun does not set anytime soon on
the land of the rising debts.
Anthony Fensom
Business & Investment Opportunities
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